Asset Allocation: The Key To Financial Success

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Use our retirement calculator. Our articles, research studies, tools, and reviews maintain strict editorial integrity; however, we may be compensated when you click on or are approved for offers from our partners. Richard Barrington MoneyRates. Understanding asset allocation To understand the nature of asset allocation, think of two people going to a grocery store -- one person heads into the store with a short list of ingredients for a specific recipe and the other fills a shopping cart with a week's worth of provisions. This is a passive-asset-allocation approach, and the only intervention needed is to rebalance the mix occasionally back to the target.

In contrast, active-asset-allocation strategies involve making significant changes to the mix according to your investment outlook. If you think stocks are going to have a great year, you would move to a heavier allocation in stocks. If you thought the stock market was heading for a bear market, you would cut back to a lighter allocation. Asset-allocation strategies should align with your long-term goals Your asset-allocation approach should be in sync with your long-term investment goals.

With a long time horizon, you can wait out some of the ups and downs of market cycles, and you are likely to need growth to keep your investments ahead of inflation. In contrast, if you have near-term needs, you would be likely to feature an investment strategy more geared toward stability and liquidity to make sure money is readily available when you need it.

This would call for a more conservative asset allocation. You can do it yourself or have asset allocation managed for you You can set your asset allocation yourself by buying separate securities or funds of different asset classes in a proportion that represents your target mix. That would leave you with the responsibility of making any changes necessary for tactical reasons or to rebalance to your target. There are also professionally managed asset-allocation funds that either maintain an allocation in line with a specified target or adjust the allocation over time in keeping with a particular goal.

Asset Allocation: A Key to Portfolio Success

Target date funds, which are popular in k plans because they set an allocation based on when the participant plans to retire, are an example of the latter approach. Both retirement plans like k programs and online brokers are likely to offer a choice between individual asset-class products that will require you to make asset-allocation decisions and asset-allocation funds that will produce an asset-allocation mix for you. There are many types of assets from which to choose Stocks, bonds and cash are the three basic asset classes commonly used; but there are a host of other choices such as real estate, commodities, crypto-currencies, etc.

Good investing is boring.

Asset allocation means allocating the right proportion of investments in different asset classes, based on your risk profile. Unless you focus on getting this right, there is little chance of creating wealth on a sustained basis over the long term. Major Asset Classes.

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Every investment option can be described in terms of its risk and return characteristics. Investments that exhibit similar risk and return characteristics, and respond in a similar fashion to economic and market events are grouped together as an asset class. There are majorly two classes of financial assets advisable for retail investors:. Equity is more volatile, however, can generate significant wealth over a longer duration, hence equity is typically used for wealth creation in a portfolio. Debt, on the other hand, is more stable, but has lesser returns in general, hence it is generally used for capital protection in a portfolio.

Investment decision process. Investment decision process consists of three distinct steps: Risk Assessment, Asset Allocation and Security Selection, each of which is important. For a successful investment journey over a longer-term, it is important to remain invested and that is possible only if your portfolio is in line with your risk appetite, investment horizon, and investment goals. Your age, number of dependents, income, etc are also some of the other important considerations.

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This risk profile assessment is the first key step in investment decision making. Thus the asset allocation will be in line with your risk profile.

The Key To Successful Investing Is Asset Allocation – Part One

Hence, depending on your risk profile, your portfolio should have a major allocation to the equity asset class. Once the first two steps are done, Security selection i.

As a class, investors have a peculiar habit of extrapolating recent events into the future. When times are good, they become overly optimistic about the prospects of their enterprises. As Graham pointed out in his landmark investment book The Intelligent Investor , the chief risk is not overpaying for excellent businesses but rather paying too much for mediocre businesses during generally prosperous times.

To avoid this situation, err on the side of caution, especially in the area of estimating future growth rates when valuing a business to determine the potential return.

Second, only purchase assets trading near in the case of excellent businesses or substantially below in the case of other businesses your estimate of intrinsic value. How much you are willing to pay depends on a variety of factors, but that price will determine your rate of return.

that is crucial to your financial success, you might be in for a surprise!

In the case of an exceptional enterprise—the type of company with huge competitive advantages, economies of scale, brand name protection, mouthwatering returns on capital, and a strong balance sheet, income statement, and cash flow statement—paying a full price, and regularly buying additional shares through new purchases and reinvesting your dividends, can be rational. Those types of businesses are rare. Most fall into the territory or secondary or tertiary quality. It's the nature of the stock market. In fact, historically, drops in quoted market value of 33 percent or more are fairly common every few years.

It would allow you to have additional downside protection in the event of another Great Depression or — collapse. How can you estimate the future earnings per share of a company? You'd build spreadsheets, run scenarios, and come up with a range of future projections based on different confidence levels.

The Key To Financial Success Is Asset Allocation

All of this requires understanding how the businesses make their money. Shockingly, many investors ignore this common sense and invest in companies that operate outside of their knowledge base. Unless you understand the economics of an industry and can forecast where a business will be within five to ten years with reasonable certainty, do not purchase the stock. From a societal standpoint, these technological advances were major accomplishments. As investments, a vast majority fizzled. The key is to avoid seduction by excitement.

The money spends the same, regardless of whether you are selling hot dogs or microchips. Forget this, and you can lose everything. These things expand the potential area of investment available to you—valuable, yet not critical to achieving your financial dreams. Even billionaire Warren Buffett , renowned for his vast knowledge of business, finance, accounting, tax law, and management, admits his shortcomings.

At the Berkshire Hathaway stockholder meeting, Buffett, responding to a question about the telecom industry, said:. This ability to examine his strengths and weaknesses is one way Buffett has managed to avoid making major mistakes over his considerable investing career. Unfortunately, many investors look to the current market price of an asset for validation and measurement, when in the long run it follows the underlying performance of the cash generated by the asset.

The lesson?